T25.

1 Chapter Outline

Options and Corporate Securities Chapter Organization

! 25.1 Options: The Basics ! 25.2 Fundamentals of Option Valuation ! 25.3 Valuing a Call Option ! 25.4 Equity as a Call Option on the Firms Assets ! 25.5 Warrants ! 25.6 Convertible Bonds ! 25.7 Reasons for Issuing Warrants and Convertibles ! 25.8 Other Options ! 25.9 Summary and Conclusions ! 25A
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Chapter 25

The Black-Scholes Option Pricing Model

copyright 2002 McGraw-Hill Ryerson, Ltd.

T25.2 Option Terminology ! Call option

The right to buy an asset at a fixed price during a particular period of time.
! Put option

The right to sell an asset at a fixed price during a particular period of time. The opposite of a call.
! Striking price

The fixed price in the option contract at which the holder can buy or sell the underlying asset. (Also the exercise price or the strike price.)

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T25.2 Option Terminology ! Expiration date

The last day on which an option may be exercised.

! Exercising the option

The act of buying or selling the underlying asset via the option contract.
! American option

An option that may be exercised at any time until its expiration date.
! European option

An option that may only be exercised on the expiration date.

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copyright 2002 McGraw-Hill Ryerson, Ltd

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T25.3 A Sample Globe and Mail, Report on Business Option Quote (Figure 25.1)

Stock Series Air Canada Jul-00

Close Bid $19.35 3.35 0.60 0.60 0.30

Ask

Last

Total Vol Op Int Vol Op Int 156 7 20 20 40 8514 592 150 230 104

$16.00 $19.00 p $20.00 $21.00

3.60 0.85 0.85 0.55

3.95 0.55 0.90 0.50

Source: The Globe and Mail, Report on Business, July 6, 2000, p. B27. Used with permission

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T25.4 Value of a Call Option at Expiration (Figure 25.2)

Call option value at expiration (C1)

Stock price 45 at expiration (S1) Exercise price (E) As shown, the value of a call at expiration is equal to zero if the stock price is less than or equal to the exercise price. The value of the call is equal to the stock price minus the exercise price (S1 - E) if the stock price exceeds the exercise price. Irwin/McGraw-Hill copyright 2002 McGraw-Hill Ryerson, Ltd
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S1 E

S1 > E

T25.5 Value of a Call Option Before Expiration (Figure 25.3)

Call price (C0)

Upper bound C0 S0

Lower bound C0 S0 - E C0 0

45 Exercise price (E)

Stock price (S0)

As shown, the upper bound on a calls value is given by the value of the stock (C0 S0). The lower bound is either S0 - E or zero, whichever is larger. Irwin/McGraw-Hill copyright 2002 McGraw-Hill Ryerson, Ltd
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T25.6 Five Factors That Determine Option Values (Table 25.1)

Factor Current value of the underlying asset Exercise price on the option Time to expiration on the option Risk-free rate

Calls (+) () (+) (+)

Puts () (+) (+) () (+)

Variance of return on underlying asset (+)

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T25.7 Terminology: Convertible Bonds ! Conversion premium

The difference between the conversion price and the current stock price, divided by the current stock price.
! Conversion price

The dollar amount of a bonds par value that is exchangeable for one share of stock.
! Conversion ratio

The number of shares per bond received for conversion into stock.
! Conversion value

The value a convertible bond would have if it were to be immediately converted into common stock.
! Straight bond value

The value a convertible bond would have if it could not be converted into common stock.
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T25.8 Minimum Value of a Convertible Bond (Figure 25.4)

Minimum convertible bond value (floor value) Convertible bond floor value

Conversion value

Straight bond value Conversion ratio Straight bond value greater than conversion value Irwin/McGraw-Hill Straight bond value less than conversion value Stock price
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T25.9 Value of a Convertible Bond (Figure 25.5)

Convertible bond value Convertible bond values Conversion value

Option value Straight bond value Floor value Conversion ratio Straight bond value greater than conversion value Irwin/McGraw-Hill Straight bond value less than conversion value Stock price
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T25.10 The Case For and Against Convertibles (Table 25.3) If Firm Does Poorly Low stock price and no conversion If Firm Prospers High stock price and conversion

Convertible bonds issued instead of straight bonds

Cheap financing because coupon rate is lower (good outcome)

Expensive financing because bonds are converted, which dilutes existing equity (bad outcome) Cheap financing because firm issues stock at high prices when bonds are converted (good outcome)
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Convertible bonds issued instead of common stock

Expensive financing because firm could have issued common stock at high prices (bad outcome)

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T25.11 Other Options ! Call provision on a bond

A call provision provides the issuer the right, but not the obligation to repurchase the bond at a specified price.
! Put bonds

The owner of a put bond has the right to force the issuer to repurchase the bond for a fixed price for a fixed period of time.
! Green Shoe provision

The right of the underwriter to purchase additional shares from the issuer at the offer price in an IPO.
! Insurance

Insurance obligates the insurer (option writer) to purchase the underlying asset at a specified price for a specified period (the term of the policy).
Irwin/McGraw-Hill copyright 2002 McGraw-Hill Ryerson, Ltd
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T25.12 Chapter 25 Quick Quiz 1. What is the difference between a call option and a put option? Call: the right to buy an asset at a fixed price during a particular period of time. Put: the right to sell an asset at a fixed price during a particular period of time. 2. All else equal, which is more valuable to the holder, an American option or a European option? Why? An American option gives the holder the right to exercise at any time during the options term; a European restricts the right to exercise to the expiration date. The former must be more valuable to a rational option holder. 3. What is the floor value of a convertible bond? The floor value of a convertible bond is the higher of the conversion value or the straight bond value.
Irwin/McGraw-Hill copyright 2002 McGraw-Hill Ryerson, Ltd
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T25.13 Solution to Problem 25.2 Consider the following options quote. Option & NY Close Strike Price Expiration Calls Vol. Last Puts Vol. Last

RWJR 74 74 74 74 70 70 70 70 Mar Apr Jul Oct 230 170 139 60 3 1/2 6 8 5/8 9 7/8 160 127 43 11 1 1/8 1 7/8 3 3/8 3 1/8

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T25.13 Solution to Problem 25.2 (concluded) a. Are the call options in the money? What is the intrinsic value of an RWJR Corp. call option? The strike price is 70 and the value of the underlying stock is 74. The call options, therefore, are in the money. Intrinsic value = $4 b. Are the put options in the money? What is the intrinsic value of an RWJR Corp. put option? The strike price is 70 and the value of the underlying stock is 74. The put options, therefore, are not in the money. Intrinsic value = $0 c. Two of the options are clearly mispriced. Which ones? At a minimum, what should the mispriced options sell for? Explain how you could profit from the mispricing in each case. The March 70 call price is $3.50, yet its intrinsic value is $74 - 70 = $4. One could buy the call and immediately exercise it, netting $.50 per share before transactions costs. The October 70 put is priced lower than the July 70 put, although the former gives the holder an extra three months. One could sell July puts and use the money to buy October puts, netting $.25 per share and an extra three months in the bargain.
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T25.14 Solution to Problem 25.4

! The price of Cartman stock will be either $75 or $95 at the end of

the year. Call options are available with one year to expiration. Tbills currently yield 4 percent. a. Suppose the current price of Cartman stock is $90. What is the value of the call option if the exercise price is $70? b. Suppose the exercise price is $90 in part (a). What would the value of the call option be?

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T25.14 Solution to Problem 25.4 (continued)

a. What is the value of the call option if the exercise price is 70? The present value of the exercise price = $70/(1.04) = $67.31 S0 = PV exercise price + C0 $90 = $67.31 + C0 C0 = $22.69 b. Suppose the exercise price is $90 in part (a). What would the value of the call option be? $90 = _____ + _____ C0 = _____
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T25.14 Solution to Problem 25.4 (conclusion)

a. What is the value of the call option if the exercise price is 70? The present value of the exercise price = $70/(1.04) = $67.31 S0 = PV exercise price + C0 $90 = $67.31 + C0 C0 = $22.69 b. Suppose the exercise price is $90 in part (a). What would the value of the call option be? $90 = $90/1.04 +(4)C0 C0 = $4.47
Irwin/McGraw-Hill copyright 2002 McGraw-Hill Ryerson, Ltd
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T25.15 Solution to Problem 25.6

! A one-year call option contract on Cheesy Poofs common

stock sells for $1,800. In one year, the stock will be worth $30 or $50 per share. The exercise price on the call option is $35. What is the current value of the stock if the risk-free rate is 5 percent?

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T25.15 Solution to Problem 25.6 (continued)

! C0 = $1,800/(100 shares per contract) = $18 per share

! S0 = ________ $18 + __ /(1.05) = $_______ = ______

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T25.15 Solution to Problem 25.6 (conclusion)

! C0 = $1,800/(100 shares per contract) = $18 per share

! S0 = $20/(50-35) 18 + 30/(1.05) = $24 + 28.57 = $52.57

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copyright 2002 McGraw-Hill Ryerson, Ltd

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